Every decent business starts with a good product or service. Something someone is willing to pay for.
Then, you need to market the product and sell enough of it so you can generate a decent chunk of revenue. Next, costs come out of revenue. So too do expenses. Then we pay interest on debt and taxes.
Finally, we're left with profit.
Profit is easy to understand to most people. Sales minus everything you must pay.
But what does this have to do with blue-chip dividend shares?
Everything.
Knowing how we go from a product to profit is vital to understanding what makes a good dividend stock.
I must admit, many people simply look at past payments and take future dividends as a certainty. But they're not certain.
Long-term investors in the share market will know it's not about what dividends have been paid, it's about what dividends will be paid.
In Australia, a company's board does not have to pay dividends to shareholders even if it has bucket loads of cash. Personally, I'd rather the company reinvest the extra cash because it tells me the managers think they have something worthwhile to spend the money on!
Having an insight into the company's profit outlook is imperative because growth will likely lead to bigger dividends, while contraction will lead to little or no dividends.
We only need to look at Woolworths Limited (ASX: WOW) to see what happens to dividends when a company with an exceptional dividend track record sees its profits fall. Its most recent dividend was 34% lower than the comparable dividend a year earlier.
Competition from Coles, Aldi and Costco is likely to continue hurting Woolies.
We also saw BHP Billiton Limited (ASX: BHP) slash its dividend due to plummeting commodity prices. Rio Tinto Limited (ASX: RIO) has kept its dividend intact, but if prices fall further it's also likely to cut its payout.
Finally, the big banks may be in the firing line for a dividend cut, or at least slower growth in payments.
The major banks have avoided proper competition for many years because they've been the beneficiaries of a regulatory environment that essentially allows them to take on more debt than the other banks and lend excessive amounts. A resources and property boom helped. So too did the lack of a proper recession during the GFC.
But now the chickens are coming home to roost and more capital raisings, or dividend cuts are likely.
Commonwealth Bank of Australia (ASX: CBA) is best placed to deal with any changes, but it's a big fish in a medium-sized pond, so recent profit growth will not continue forever. Westpac Banking Corp (ASX: WBC), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ) are also likely to cut dividends if things get a little tough.
A model dividend stock
Each of the above companies are reputable, quality businesses. However, as every financial advice disclaimer should read: Past performance is not indicative of future performance.
If I were starting out in the market today, I wouldn't buy any of the shares above for their dividends. The stock I'd choose to buy would, firstly, be growing profits rapidly (and likely to continue doing so) and have a strong balance sheet. Only after that would I expect to receive dividends.
